J Crew

Executive Summary

J Crew, a high end specialty retailer, is a buy. It continues to be an early stage turnaround story. The key to this stock is management, led by retailing legend Mickey Drexler, who successfully revitalized both Ann Taylor and The Gap. He is expanding the J Crew brand into new market segments, with both the Crewcuts and Madewell concepts, and is trying to reinvent and differentiate the brand as he successfully did with The Gap. He is improving efficiency and focus, creating improved margins and future cash flows. The stock has nearly doubled since the IPO in late June and thus the near term valuation, with a forward PE of 30 the street’s estimates, is pricing in much of these positives. Nevertheless, given Mickey’s track record and the many areas of growth, J Crew earnings growth should accelerate beyond current street estimates.

Business and Strategy

J Crew is positioned in the low high end segment of the specialty stores, targeting the 25-45 year old group. They have not fully saturated their market, currently operating only 170 retail stores, and 50 factory stores. Factory stores are not limited to liquidate inventory and are more profitable because of higher volume. Sales are 68% women, 18% men and 14% accessories, with 70% sold in stores and 30% directly. Direct sales are split 63% internet, 37% catalogue; thus as internet becomes a larger percentage of direct sales operating margins should improve, as catalog distribution is a large part of the SG&A. While none of their competitors are quite their style or targeting the same audience, their closest competitors are Banana Republic, Ann Taylor, Polo Ralph Lauren, Rhuel and Martin + Osa. While not in their space, Coldwater Creek is a good comparable with the similar seamless multi-channel approach.

Mickey Drexler’s strategy has been to close underperforming stores and downsize larger ones. His goal is maximizing revenue vs. floor space by opening smaller more profitable stores, showing he is focused on the bottom line, not just growing revenues or sales by opening too many, larger stores (the mistake he made in his finals years at The Gap). In clothing he is trying to compete on quality instead of price, branding the clothing “guilt free luxury”, which gives them better pricing power. J Crew is going for clothes that are classics and consistent, thus there is much less risk that the clothes are a fad and will go out of style. He is exiting areas of clothing that J Crew could not compete well in such as suits. All of this shows a focus and drive to maximize and grow profits, consistent with the numbers.

Management

Mickey Drexler is widely respected in the retail industry, most importantly for making Gap into a retail giant. He still has something to prove, having made mistakes at the end of his time at The Gap, and has learned from them. He has a large equity stake, owning 13% of the stock, is meticulous and understands how to build and cultivate a brand. He is attempting to expand J Crew’s market segment as he did with The Gap. He has brought with him a deep management team with over a century of experience, all who worked with him at The Gap (except the CFO).

Growth

Growth forecasts of 20% over the next several years are likely conservative given continued margin expansion and new opportunities which will come from three main sources. After fixing existing stores and closing unprofitable ones, J Crew is ready to expand its stores initially with a target of 300 stores at about 25 stores a year. The second source is their new concept, Crewcuts, which represent smaller, “mini me”, versions of the adult clothes, for 2-8 year old kids. It will be virtually all incremental growth, with very little capex. This is because Crewcuts shelf space replaces men’s clothing space and management has noticed no drop off in men’s sales and there are no extra fashion design costs. The third source is their new concept; Madewell which is a “cooler more hip” all women clothing line meant to bridge the gap between the teen clothing market and J Crew, priced 20-30% lower. So long as it doesn’t cannibalize J Crew, it should be a good growth opportunity as it goes with Mickey’s track record.

Financials

J Crew’s financials have seen a dramatic improvement since Mickey took over the company. He has returned it to profitability, and generated 11 straight quarters of same store sales growth (16% in 2004, 13% in 2005). Debt has been paid down and free cash flow is expected to be used to continue to de-leveraging the capital structure, which will reduce risk and improve profit margins. Gross margins also have improved to 41.8% in 2005 The efficiency of his turnaround efforts can be seen both in sales/sq foot which have increased from 338 in 2003 to 457 in 2005 and operating margins which have increased from -4.3% in 2003 to 8.3% in 2005, 2006 margins around 10.5%. With a forward PE of 30, given street estimates of 1.21, and a PEG of 1.25 J Crew is expensive relative to peers trading mostly at PE ratios of 20-25. However, what is not being priced in by the street is meaningful continued margin expansion with most of the street looking for no more than 100bps. Thus, there is room for EPS upside given gross margin growth and SG&A leverage.

Risks

The main risk is that all of these positives are fully priced in. A great company or great turnaround story does not always make a great buying opportunity and J Crew is definitely expensive at 30 times forward earnings. The loss of Mickey Drexler would be a devastating blow, as he has engineered the turnaround. His importance is further exemplified by the 15% overnight drop in The Gap’s market value when he was fired. Further, J Crew does have a much higher level of debt than competitors, potentially effecting cash flows needed for expansion or competing with rivals like the Gap, who while mismanaged, have a stronger balance sheet. It is also too early to tell whether Madewell is a good investment and if it will generate much growth. Additionally, the expansion may cannibalize some of the direct sales as geographical areas without access to stores gain them. Finally, J Crew is potentially a company caught between other brands without a sustainable competitive edge and once Mickey improves efficiency and operations, further growth may be limited by rivals.

Conclusion

J Crew’s execution, strategic vision and focus on profitability, as shown by the current success of the turnaround, should create long term earnings power and great upside potential over the next few years. Any weakness off of a soft holiday season for retail or selling pressure from the lockup expiration of Texas Pacific’s 38% holding should be viewed as a buying opportunity